AIG may still be too big for government to let it fail

Insurer's shares slump on report of debt-for-equity swap with government

By

AlistairBarr

SAN FRANCISCO (MarketWatch) - American International Group is still too big and inter-connected with the rest of the financial system, so the U.S. government will likely take more drastic steps to help the insurer avoid what could be fatal credit ratings downgrades in coming weeks, analysts said Tuesday.

AIG
AIG, -2.06%
is expected to report a quarterly loss of roughly $60 billion next Monday, the Wall Street Journal reported, citing unidentified people familiar with the matter.

"The loss would most likely result in credit rating downgrades which would in turn lead to additional collateral calls," CreditSights, an independent fixed-income research firm, wrote in a note to investors.

Downgrades last year by Standard & Poor's and Moody's Investors Service almost felled AIG and forced the government to bailout out the insurer with an $85 billion loan in return for an equity stake of almost 80%. The bailout ballooned to $150 billion in a November package that included a new $60 billion loan and $40 billion of government investment in perpetual preferred shares issued by AIG.

The government is going to such great lengths to prop up AIG because it is one of the world's largest counterparties in the market for credit default swaps, a common type of derivative that protects investors against default.

If AIG collapses, counterparties including several major European financial institutions could be left waiting to be repaid along with other creditors in bankruptcy. Such a scenario could bring the financial system to its knees as nearly happened when Lehman Brothers
LEHMQ
collapsed in September.

"The Federal government is maintaining a life support system for AIG," said Sean Egan, president of Egan-Jones Ratings, a rating agency that's paid by investors rather than investors. "If they pull the plug, they are dead. We don't want that to happen yet."

An AIG spokesman said Monday that the insurer is evaluating "potential new alternatives" with the Federal Reserve Bank of New York to tackle its problems. He declined to comment further, as did an AIG spokeswoman and a New York Fed representative on Tuesday. See full story.

Under the new plan being considered for AIG, the $60 billion government loan will be repaid with a combination of debt, equity, cash and operating businesses, Wall Street Journal reported. The re-organization, which amounts to a debt-for-equity swap, will be announced next Monday when AIG reports fourth-quarter results, the newspaper added.

Assets, such as AIG's Asian life insurance businesses, would be transferred to the government instead of cash to repay some of the $60 billion loan, the newspaper explained.

AIG shares slumped 26% to 39 cents on Tuesday.

The government is trying to buy more time to unwind some of AIG's operations and sell other assets, so that if the insurer collapses or shuts down in future it won't affect the broader economy much, Egan explained.

"In 12 to 24 months there will be a decision to shut AIG down or allow more private capital in. By then, AIG will hopefully not pose such a threat to the broader economy," he said.

The government is "doing the right thing" to try to maintain order in financial markets and the broader economy, but it made a serious strategic mistake several years ago when it allowed AIG to "massively mis-assess and mis-price risk." Egan stressed.

In November, AIG estimated that if Moody's and S&P downgraded its long-term senior debt ratings one notch, the insurer would have to come up with almost $8 billion in collateral and termination payments for counterparties.

A two-notch downgrade would let counterparties terminate CDS contracts that cover $47.8 billion in debt. AIG said in November that the cost of replacing those contracts could not be reliably estimated.

The government has helped AIG unwind a lot of these contracts since November, but some of the agreements are tougher to settle. See full story.

It's also unclear whether the reported re-organization of the government's loan will avoid a ratings downgrade of AIG.

A debt-for-equity swap is often considered a "de-facto default" Egan said on Tuesday. Under normal circumstances, that would be very bad for a company's creditworthiness and ratings, he explained.

However, ratings for large, important companies like AIG involve political as well as credit analysis, Egan added.

The government has some influence over leading rating agencies like Moody's and S&P, however any attempt to persuade them to delay a downgrade of AIG would undermine confidence in ratings in general, Egan said.

"We're in the twilight zone of credit analysis," he continued. "AIG clearly cannot meet its obligations, but the Federal government has shown willingness to backstop the institution."

Spokesmen for Moody's, S&P and Fitch Ratings declined to comment on Tuesday.

Moody's and S&P said in October that they were reviewing AIG ratings for a possible downgrade.

In January, Moody's made it clear that continued government support was crucial.

"The current ratings on AIG and its subsidiaries reflect Moody's expectation of continuing support from the US Government," the agency said on Jan. 14.

Such support helps AIG meet short-term liquidity needs, while giving it time to sell businesses and unwind contracts written by AIG Financial Products Corp., its derivatives unit, the agency explained.

"Without such support, the ratings of AIG and many of its subsidiaries - including core operations and businesses identified for sale - would be lower," Moody's warned.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information.
All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only.
Intraday data delayed at least 15 minutes or per exchange requirements.